One shoe does not fit all

Financial engineering and thousands of job losses do not really describe the practices of your average lower to mid-market private equity fund. Working with management teams, winning over family-owned companies through local networks, organic growth and longer holding periods, the mid-markets would argue, are more applicable key catchphrases.

So, if the larger end of the market is smarting from what it sees as unfair and ungrounded political attacks on their practices and industry in general, how do mid-market firms feel?

This point is especially pertinent, perhaps, given that family-owned businesses throughout Continental Europe are only now getting used to private equity. The “locust” debate in Germany a couple of years ago did nothing to help the private equity cause among such companies – potentially the bread and butter for mid-market funds.

However, recently the tide has been turning. In Germany – the home of the locust debate and also of a stubborn swathe of family-owned Mittelstand companies that historically have refused to be involved with private equity – sentiment has begun to change. Will this recent negativity set back the mid-market cause once again?

Buchan Scott of Duke Street Capital says: “There is a huge difference between mid-market deals and large buyouts. Over the last three years, these differences have become more and more accentuated. The present debate needs to become much more focused. Even VC firms are getting dragged in. It is the features of the large-scale deals that people are complaining about.”

Scott argues that both the business model and the fee remuneration enjoyed by mid-market firms are different from those of Duke Street’s larger peers.

“In the mid-markets there is more emphasis on value creation than financial techniques,” he says. “And on the issue of fat cat fees that surrounds the larger firms, all I can say is that mid-market firms are a million miles different. We typically charge 1.7% management fees and most of this goes on costs, mainly premises and salaries. We don’t make much money on fees. You need the same resource to do a £30m deal as a £30bn deal, which does not work in our favour,” says Scott.

Philip Buscombe at Lyceum Capital agrees: “Our part of the market is a very different place to the larger end. It is a very supportive environment. We buy entrepreneur-owned or orphaned subsidiary companies and if we can’t improve their long-term profitability, we cannot make returns. The debt plays a very small part.”

On the issue of fees Buscombe agrees with Scott. “We are not fee driven in the mid-market,” he says. “Every time I buy and sell a company, I have to give money back to investors. On a daily basis we have to prove our worth. After four or five years investing a fund we have to go back to our investors and ask for more money.

“It is a highly competitive environment,” he says. “If they don’t feel that the management fees are value for money, they simply won’t pay them. We are not making a huge surplus in the management group just sufficient to run the company well and this is the same with most mid-market firms.

It is only if you keep the same number of employees but increase the fund size that you get a real surplus,” Buscombe says. “Our investors ask what we need every five years. We might say we need more employees or resources – it is a very transparent process where a lot of work has been done to align our interests with that of the investor.”

Buscombe further argues: “We have always been very transparent and we voluntarily prepare a lot of data regarding issues we feel investors need to know about a portfolio company, which would include employment reports.”

But he is worried that a call for more transparency in the industry could put untenable burdens on smaller firms.

“Any rationale person will see that if you want to buy Sainsbury, then fair enough there might have to be different disclosure, Buscombe says. “But we do not believe that we should be burdened with the same level of reporting on a £50m company as a £2bn one. We don’t want a ‘one shoe fits all’ regulation.”

However, the British Venture Capital Association (BVCA) has gone some way in allaying these fears. Last week, it announced that it would form a working group under the chairmanship of Sir David Walker to examine ways in which levels of disclosure in companies backed by the UK private equity industry could be improved.

In a statement it said: “The working group will recognise the very different types of investment and issues relating to different segments of the industry, from small start-up financing to large buy-outs. It will also take account of the size of the portfolio companies concerned.”

Chief executive of the BVCA Peter Linthwaite, talking to IFR Buyouts, reiterated this point: “I am sure one of the things discussed by the working group will be what is proportionate and appropriate for different levels of the community,” he said.

Also, the mid-market players appear to agree that a debate could actually further their cause among family-owned companies and other potential vendors.

“It is good to get the debate out into the open. There is a lot of misunderstanding over how private equity works. This debate will clear this up and people will come out better informed, so in that sense it is a good and positive thing,” says Scott.

Buscombe agrees, saying: “By-and-large, the industry is responsible and the mid-markets will come well out well from these discussions.”